The Delaware bench trial between pipeline giants The Williams Companies and Energy Transfer ended Monday following testimony on an issue of death and taxes.
The testimony from 10 tax experts, six of them lawyers, gave a behind-the-scenes peek into a controversial tax issue responsible for killing a $38 billion merger between Williams and Energy Transfer’s predecessor, Energy Transfer Equity.
The issue? There was a death, but would there have been taxes?
Williams’ lawyers at Cravath, Swaine & Moore said “no”; Energy Transfer’s tax experts said, “Looks like it,” and their lawyers at Latham & Watkins agreed.
At issue is the “721 Opinion,” which alludes to Section 721 of the Internal Revenue Code, a provision that governs whether a transaction will be tax-free. At stake is the deal’s $410 million merger breakup fee.
There are different levels of a 721 opinion: a “will-level” opinion, a position meaning the transaction “will” be tax free, which one witness testified as being the most brazen position (and negligence- prone position, if the tax lawyer ends up being wrong); a “should-level” opinion, the more common level among deals, which means the transaction “should” be tax-free; and a “more-likely-than-not-level” opinion, which at this point is entirely self-explanatory.
This was the second time that many of the tax-focused witnesses testified before the case’s presiding Vice Chancellor Sam Glasscock III of the Delaware Court of Chancery.
In the first trial in 2016, Vice Chancellor Glasscock determined ETE was legally allowed to terminate the deal. A major issue at that trial was whether ETE’s outside tax lawyers at Latham & Watkins acted independently and in good faith when they determined they would not be able to reach a “should-level” opinion. Glasscock determined that the Latham lawyers did.
Witnesses for Energy Transfer testified again at length about the decision-making process that went behind Latham’s refusal to deliver a “should-level” opinion, while witnesses for Williams provided the reasoning behind their belief that Latham’s approach went against the industry standards used in structuring thousands of deals in the U.S. each year.
The facts surrounding the tax issues will help Glasscock determine which side breached the obligations of the merger agreement; that, in turn, will help decide who is on the hook for the $410 million merger breakup fee.
As the vice chancellor receives post-trial motions and closing arguments from the parties in the coming months, one particular issue he will consider is which side correctly followed an extremely complicated area of tax law that doesn’t currently provide much guidance to practitioners.
Latham’s position at trial was that it was unable to deliver an opinion because the transaction’s structure could be bad news for case law established in Commissioner of Internal Revenue v. Court Holding Co., a 1945 U.S. Supreme Court decision which held that a transaction agreement could not be restructured solely for tax purposes. This argument came into play because Cravath proposed two modifications to the transaction’s structure that the lawyers believed would resolve the tax issue. Williams argued at trial that its two proposals would have resolved the tax issues and that Court Holding did not apply to the proposals.
The new trial has revealed that the Williams-ETE deal was already facing significant hurdles and points of contention by the spring of 2016. But testimony from the second half of trial revealed that what officially dug the grave for the mega-merger was what Energy Transfer tax professionals considered a fatal problem they first noticed on a draft of one of the company’s S-4 filings.
ETE agreed to acquire Williams in September 2015 through a hybrid deal model that included a cash component and a stock component. The cash portion of the $38 billion deal involved a hook stock transaction in which ETE would purchase 19% of shares of ETC, the newly created entity that the Williams shareholders would own, in exchange for $6 billion.
Energy Transfer CFO Brad Whitehurst, who was previously ETE’s head of tax, and his subordinate, Darryl Krebs, testified last week that their original understanding of the deal was that the 19% of shares were for a floating value instead of a fixed value. Whitehurst and Krebs testified that they noticed it was actually the opposite after reviewing a draft S-4 filing.
Whitehurst and Krebs said this was problematic because acquiring fixed shares meant that, in light of the energy crisis-triggered decline in stock prices, ETE was paying $6 billion for ETC shares that were only valued at $2 billion at the time, causing a $4 billion delta that they believed could trigger a taxable gain.
Whitehurst testified that this realization prompted him to ask ETE’s tax counsel at Latham to look into the issue and determine whether they could still deliver a should-level tax-free 721 opinion, which was a prerequisite to the deal closing.
What followed is two very different versions of the story. But what was apparent after hearing from all sides is that this situation was so tense that it even pitted friends against each other.
Cravath’s Version
Williams’ lead tax lawyer, Cravath partner Andrew Needham, began his testimony with utmost confidence in one fact: that the Willaims-ETE merger would have been tax-free, and that he had no concern over whether it would qualify.
He said that he first learned Latham did not share that position when Tim Fenn, ETE’s lead tax lawyer and a partner in Latham’s Houston office, emailed Needham in April 2016 to schedule a call. On the call, Needham and his law partner Chris Fargo heard from Fenn and Latham’s second lead partner on the deal, Larry Stein, that the deal had a potential tax issue and jeopardized Latham’s ability to deliver a “should-level” opinion.
Needham said Fenn and Stein explained that the decline in stock value meant that the hook stock leg of the transaction was no longer at arms-length and that they believed the IRS could reallocate the cash paid for ETC shares to Williams assets as taxable income. Unless the stock recovered to signing date value, Latham would be unable to deliver a 721 opinion, Needham recalled Fenn and Stein saying. Fenn and Stein described this scenario as a “perfect hedge.”
Needham said that he and Fargo consulted with some other Cravath colleagues after the call to look into the issue in more detail and “figure out what Latham could possibly be thinking,” and later that day, they called Fenn and Stein back, saying they “disagree with their analysis,” that Cravath wasn’t aware of any authority that supported Latham’s position and that Cravath and Williams “intended to assert our rights under the merger agreement.”
The next day, Needham said he got a call from Morgan Lewis partner Bill McKee, whom ETE had hired to give a second opinion on the 721 issue. Instead of a “perfect hedge” issue, McKee described to Needham what he viewed as a cherry-picking issue, which Needham said “tends to involve the allocation of stock and non-stock consideration of attributable assets for tax avoidance.”
After the call with McKee, Needham said the Cravath team did more research and presented two proposals that they felt would address Latham’s concerns.
“We very much wanted to close the deal,” Needham said. “We expected them to respond to our proposals, but for two full weeks, Larry Stein, Tim Fenn, Bill McKee and Will Nelson (McKee’s law partner) never responded. Not a phone call, not an email, nothing.”
Given the severity of this issue, which could be described as a tax lawyer’s worst nightmare, Needham said he expected two things to happen: “First would be a phone call saying, ‘Thank you, that’s really great, I think we can close now,’ or alternatively a call indicating why they believed the proposals don’t work,” Needham said. “But that’s not what happened.”
Instead, Needham said he received an email from Latham with a rider attached that said ETE had no obligation to even consider either of Cravath’s two proposals.
“I frankly thought it was outrageous,” Needham said.
While the parties were negotiating the deal in 2015, Needham described Latham and ETE as “completely collaborative,” but after the tax issue “it was the complete opposite of that.
“In my experience as a tax lawyer on a deal, whether it’s public or private, I’ve never had any experience anything like this,” Needham said. “Tax opinions in closing conditions are not trap doors that convey free lock rights merely because one party gets cold feet.”
Latham’s Version
Stein completely disagreed.
“Latham was open to collaboration from anyone, including Cravath,” he said from the virtual witness stand Friday. “This was an embarrassing situation for us. If there was a way to get there, we were open to hear it.”
After Whitehurst raised the issue to Latham, Fenn testified that the firm took an “all hands on deck” approach in which the firm pulled all of the Houston tax associates from what they were doing to research the issue and consulted with several other partners. ETE had given Latham the clearance to throw all the time and resources necessary at getting to the bottom of this, and even so, roughly 1,000 billable hours later, Latham still couldn’t get to a should-level opinion, Fenn said.
Stein described the same-day follow-up call with Cravath as “frosty” and said during the call that Cravath conveyed that they’d deliver a “will-level” opinion, which he said among the tax bar, does not get thrown around casually.
“It’s the highest level of opinion that one gives — higher than ‘should,’” Stein said. “It’s not an insane opinion but virtually it’s an almost negligible risk.”
In response to why it took Latham so long to get back to Cravath on their proposed modifications, Stein said he didn’t “share that view — particularly because they talked internally at-length before the first call with Cravath where they first raised the issue.
“We didn’t want to raise an issue that wasn’t an issue … we wanted to be confident that it was at least a significant issue,” Stein said. “Same with the restructuring proposals. We wanted to work through them and make sure that they either worked or didn’t work. We didn’t want to talk to them until we got our ducks in a row for our own thinking.”
Lawyers at Latham, Cravath, ETE’s Brad Whitehurst and his counterpart at Williams, Vice President of Tax Tony Rackley, got on a call in late April 2016 to go over Cravath’s two proposals. Stein said that his side conveyed the message that neither proposal would work because they would require the parties to revise the merger agreement. Latham advised that, based on case law, the deal could not be restructured solely to avoid taxes.
In late April, Stein said that Steve Gordon, a Cravath tax partner deal who had been on the group call and whom Stein considers a friend, called him to talk one-on-one.
“He said, ‘This could get ugly, it could end up turning into litigation.’ There could be lots of nasty allegations made, and they’re just allegations, but it’s going to be out there and it’s not gonna look good for Latham,’” Stein recalls Gordon telling him.
Fenn testified that five years later, the Latham team would not have done anything differently and that he “absolutely” never doubted the integrity of Latham’s process.
“I’m confident we did everything possible we could do to run this into the ground and have the conclusion we did that I was confident about at the time, and I’m still confident about,” Fenn said. “We’re still where we were five years ago.”
Other Viewpoints
Williams spent a significant amount of time questioning Wachtell, Lipton, Rosen & Katz partner Eiko Stange or others who had conversations with him. Stange is a tax partner who was part of a team of Wachtell lawyers who led the corporate end of the deal for ETE. Stange played a small role in the ETE legal team’s discussions about the tax issue.
Williams’ lawyers allege that ETE — Whitehurst in particular — stopped Latham from discussing the tax issues with its other advisors and with Cravath, which Williams says is evidence of ETE’s failure to meet its obligations in the merger agreement.
During Whitehurst’s cross-examination, Cravath partner Antony Ryan brought up an April 7, 2016 call with Stange. He asked Whitehurst if he had asked Stange to take a look at the 721 issue. Whitehurst answered that he didn’t think it was relevant and said he couldn’t recall speaking with Stange after the April 7 call. In a court filing, Williams contends that Whitehurst never talked to Stange again because Stange had expressed skepticism about Latham’s inability to deliver a 721 opinion during that April 7 call.
Stange testified by video deposition right after Whitehurst’s live deposition concluded Friday morning.
During his testimony, he confirmed that he wasn’t asked to look at the 721 issue and that he was surprised to learn Latham said it may not be able to deliver a 721 opinion, but he explained that was because his involvement after the signing of the merger agreement “had been severely limited,” so he wasn’t up to speed on what had been happening.
“I was surprised because when we signed in September, there was an expectation that this opinion would be delivered, and there was now concern regarding the ability to deliver an opinion,” Stange testified.
He also confirmed that he disagreed with the views of McKee, the Morgan Lewis lawyer, who suggested the transaction agreement was “flawed from the outset” during a separate April 2016 phone call because of reasons that Stange thought “may have been” because of cherry-picking issues. Stange said he disagreed because the deal had been “structured by three capable firms.
“I didn’t mean to criticize the structure,” Stange clarified. “I wasn’t able to evaluate the substance, it was an immediate knee-jerk reaction to say, ‘What is this all the about?’ I didn’t at the time consider what the substance of the argument was.”
Toward the end of his deposition, Stange said he was unaware of the involvement of Eric Sloan, a tax partner at Gibson, Dunn & Crutcher who ETE alleges Williams secretly engaged to weigh in on the 721 issue and, during his analysis, expressed skepticism about issuing a “should-level” opinion. ETE alleges Williams hid Sloan’s involvement not only from ETE, but also from the Williams board of directors, and that Williams fought producing any discovery related to Gibson Dunn.
In the same way that Williams questioned many ETE witnesses during trial about conversations with Stange, ETE questioned witnesses quite a bit about Sloan’s involvement. Both Stein and Fenn testified that they were not aware of Sloan’s involvement until they had already touched down in Delaware for the 2016 trial.
Sloan was the last witness to testify at trial and appeared by video deposition.
During his testimony, Sloan said that after putting “a lot of work” into his analysis, he concluded with no doubt “at all” that a should-level 721 opinion could be reached. Like Fenn and Stein had testified, Sloan said that he didn’t feel pressure “at all” from his client to reach a particular result.
He said that Williams engaged him to play a “very narrow role,” and that he didn’t think to reach out to Latham while examining the issue because “it was a pretty charged atmosphere” at the time.
“Just given what I knew from the popular press, [the deal] seemed to be pretty contentious,” Sloan testified Monday afternoon.
But he also testified that once he reached his conclusion about the should-level opinion, he found Latham’s position to be “specious” and lacking in “merit.”
“It’s inconsistent with the way thousands of deals happen every year in this country and around the world,” Sloan said. “People strike a bargain at the moment in time when the value is right, [which] is the moment in time when they strike the deal. The fact that values move doesn’t … mean the parties are misadvising [about] the value; it’s simply a real-world reality that values move over time.”
ETE argued in court documents and at trial that Williams, in part, was so secretive about Sloan’s involvement because during a call with Cravath lawyers toward the end of his evaluation, he described the 721 issue as a “close call” and allegedly said at one point they “wouldn’t get to a should.”
Under cross-examination, Vinson & Elkins partner David Cole questioned Sloan about his wording choices during the call, and Sloan said he did not remember expressing that view. He disputed the accuracy of notes by a Cravath associate that brought these comments to the other side’s attention in the first place but also refused to call the notes inaccurate per se.
“I don’t question if they’re accurate, but if they’re intended to reflect my view, it’s inaccurate,” Sloan testified.
“Help me understand the other possibility, then,” Cole replied.
“That she made an error,” Sloan replied. “She was months out of law school, it wouldn’t surprise me if she didn’t know what we were saying.”
Cole pushed Sloan again to testify that the Cravath notes are inaccurate.
“It’s that whoever took the notes don’t reflect my views now.”
Cole asked Sloan if he had any document that disputes the Cravath notes.
“I don’t take notes during calls,” Sloan answered, “and I was never asked to produce anything in writing. But if someone wants to pay me to, I will.”
A day after the Cravath call, Sloan concluded in an email to Williams that he had reached a “weak should.”
Cravath’s Ryan, handling direct examination, asked Sloan to elaborate, and he replied that a “weak should” only meant that it’s in the 70% to 80% range of success on the merits if the 721 issue goes to litigation and had been examined by “qualified counsel on both sides.
“Most people think of it as 70% to 85%,” he said. “I was trying to indicate that … I was a tick below 75, as opposed to something just about in ‘will’ territory.”
ETE said in court filings that Williams filed its lawsuit against ETE the day after Sloan reached his conclusion.